Grocers. Audit Manual. Chapter 9. Sales and Use Tax Department California State Board of Equalization

Transcription

1 Audit Manual Chapter 9 Grocers Sales and Use Tax Department California State Board of Equalization This is an advisory publication providing direction to staff administering the Sales and Use Tax Law and Regulations. Although this material is revised periodically, the most current material may be contained in other resources including Operations Memoranda and Policy Memoranda. Please contact any board office if there are concerns regarding any section of this publication.

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3 GROCERS Table of Contents GROCERS INTRODUCTION General Audit Procedures TOTAL SALES General Verification of Total Sales Verification of Total Sales Purchase-Ratio Method Verification of Total Sales Markup Method Using Income Tax Returns in Verification Barter System Sales of Capital Assets Coupon Redemption California Redemption Value (CRV) Lottery Miscellaneous Other Sales PURCHASES SUBJECT TO USE TAX Types Self-Consumed Merchandise in Grocery Audits Procedure Where Withdrawals of Merchandise Have Not Been Reported Procedure Where Merchandise Withdrawals Have Been Reported Capital Expenditures Purchases Subject To Use Tax AUDIT OF CLAIMED DEDUCTIONS General Sales For Resale Sales of Food Products For Human Consumption Combination Food Packages Reimbursement For Sales Tax Included in Total Sales Federal Food Stamps Trading Stamps Bottle Deposits and Over-Rings Meat Scraps Sold As By-Products Bad Debts Miscellaneous Other Deductions GROCERS REPORTING METHODS General Retail Inventory Method Extending Taxable Merchandise to Retail Method Sales Tax Ring-Up Method Taxable Sales Ring-Up Method Estimates

4 AUDIT MANUAL TABLE OF CONTENTS (CONTINUED) PURCHASE-RATIO METHOD General Exempt Food Purchases Taxable Grocery Purchases Self-Performed Costs Total Grocery Sales Beverage Department Sales Verification of Segregation Purchase Discounts and Allowances Nongrocery Taxable Items Nongrocery Taxable Markup Short-Cut Procedure MODIFIED PURCHASE-RATIO METHOD General Grocers Must Substantiate Procedure Board Review Of Specific Procedure COST PLUS MARKUP METHOD TAXABLE MERCHANDISE General Grocer To Use Specific Procedure Board Review of Specific Procedure SHRINKAGE Reporting Methods Evidence of Additional Losses Audit Adjustments CREDIT FOR CLOSING INVENTORY BOARD APPROVAL OF SPECIFIC REPORTING PROCEDURES Approval Guidelines ELECTRONIC SCANNING SYSTEMS General Purchase Segregation May Be Required Board Review of Specific Procedure Record Keeping Requirements

5 GROCERS GROCERS INTRODUCTION GENERAL For purposes of this chapter, a grocer is a retailer whose principal business is the sale of food products and related items. The term includes separate grocery departments in department stores, but does not include delicatessens, country or general merchandise stores, and establishments that handle groceries as a sideline. A problem often arises in audits of liquor stores with a substantial volume of sales of merchandise normally sold in grocery stores. Whether these qualify as grocery stores will depend on the fundamental nature of the business. Generally, in order to fall within the definition of a grocery store, at least 50% of the total sales should be comprised of exempt food products and taxable grocery sales. See Exhibit 8 for examples of taxable grocery items to determine if the taxpayer meets the definition of a grocer. AUDIT PROCEDURES Due to the diverse nature of the retail grocery industry, auditing procedures must be flexible enough to meet every condition encountered. Procedures appropriate for use in auditing the corner grocery store may not be the same as those used in auditing chain store operations. The instructions and suggestions which follow are not intended to be rigid and inflexible, but are designed as guidelines which can be followed to help simplify and attain more uniformity in grocery store auditing. Reasons for major deviations from procedures outlined in this chapter should be fully explained in audit working papers. Many of the provisions of Regulation , Reporting Methods for Grocers, have major significance only for the larger grocers. In applying the regulation to audit situations, primary consideration should be given to materiality. The taxpayer should always be advised of correct reporting procedures, whether the purchase-ratio, markup or any other method of reporting is used. If errors are deemed immaterial and no adjustment is made, auditors must inform taxpayers of the proper reporting procedures with appropriate audit comments referencing information and/or instruction given to the taxpayer. The audit method should conform to the taxpayer s method of reporting insofar as it is practical and possible. The auditor is justified in using an audit method different from the method of reporting used by the taxpayer if: (a) The taxpayer s records are fragmentary and incomplete, making proper verification impossible. (b) Use of the taxpayer s method produces an unrealistic or illogical result based on preliminary testing of the book markup and/or taxable markup. If the taxpayer has used more than one reporting method during the audit period, the auditor should use the method used by the taxpayer for each reporting period unless it can be shown that total sales are not properly recorded. August 2004

6 AUDIT MANUAL TOTAL SALES GENERAL Chapter 4 of the Audit Manual outlines various procedures for verifying total sales in general. Much of this material is applicable to audits of grocers. VERIFICATION OF TOTAL SALES The degree of verification of total sales will depend to some extent on the reporting method used by the taxpayer and the audit method used by the auditor. VERIFICATION OF TOTAL SALES PURCHASE-RATIO METHOD When the purchase-ratio method is used to verify the sales of food products, it is essential that total sales first be established as being accurate. If total sales are impeached, the mark-up-method should be used for audit purposes. VERIFICATION OF TOTAL SALES MARKUP METHOD Where it is necessary to mark up purchases to determine taxable sales, the verification of total sales is not essential. In some instances, however, it may be desirable to verify total sales as further support for recommended determinations or refunds. USING INCOME TAX RETURNS IN VERIFICATION Income tax returns may be of value in the verification process. However, they cannot be expected to be more accurate than the records from which they were prepared. They are sometimes useful as supplemental verification of purchases, cost of sales or sales and are a possible source of information regarding acquisition and disposition of capital assets. Differences between reported sales per income tax returns and sales tax returns do not necessarily mean the latter have been prepared inaccurately. The procedures set forth in Chapter 4 of the Audit Manual should be followed where these differences are present. BARTER SYSTEM It is not uncommon for grocers operating in rural areas to purchase farm products from their customers. In many instances, the farmer trades his/her products for staple groceries and supplies. The auditor should verify that the value of the merchandise so traded is included in sales and purchases. SALES OF CAPITAL ASSETS Taxable sales of equipment generally can be verified by examination of general ledger accounts, cash receipts records or income tax returns. Generally, tax applies to the sales of tangible personal property held or used in the course of an activity requiring the holding of a seller s permit. Sales of fixtures and equipment used in a grocery store are subject to tax regardless of the fact that certain fixtures and equipment were used exclusively in selling food products. For example, a sale of fixtures and equipment used exclusively in the meat department operated under the same ownership as the grocery store in which it is located is subject to tax because the property was used in a business requiring a seller s permit. (See Regulation 1595.) Sales of fixtures and equipment used exclusively in a business for which a seller s permit is not required may be exempt as occasional sales. For example, the sale of a refrigeration unit used in a meat market making no sales of dog food, bones, or any taxable items would be exempt unless such sales qualify the taxpayer as a retailer of equipment.

7 GROCERS COUPON REDEMPTION There are many types of coupon redemption plans used by grocers. Several of the most common types of coupon redemption plans are discussed below. Manufacturer s Coupons Grocers often redeem coupons for manufacturer s products. The manufacturer may handle the distribution of the coupons or may authorize the grocer to publish a coupon in a newspaper or handbill advertisement. The coupon offers the bearer a specified amount off the regular price of the manufacturer s product, and the manufacturer agrees to pay the retailer for each coupon redeemed plus an amount for handling. Amounts paid by a manufacturer to a retailer for coupons redeemed by the retailer, exclusive of amounts paid for handling, constitute gross receipts of the retailer. If the amount paid by the manufacturer, exclusive of handling, is less than the face value of the coupon, only the amount paid is includable in the retailer s gross receipts since there is no consideration for the difference. Many stores use coupon redemption centers that make a charge for their services. If the service charge made by the coupon redemption center is greater than the handling charge permitted by the manufacturer, the excess charge may not be deducted from gross receipts. Regardless of the reporting method used by the grocer, the auditor should verify that amounts received or accrued by the grocer for the redemption of coupons are treated as gross receipts from the sale of the product and not as a reduction of purchases. Retailers Coupons Many grocers publish or send out free coupons that are redeemable for merchandise at their store and are not reimbursed in any manner by a manufacturer. The face value of the coupon is a cash discount. Consequently, tax applies to the selling price after the discount. Cash discounts for taxable products are deductible from reported taxable sales if the full amount of the sale, without deduction for the discount, is included in the grocer s reported total sales. Double-Discount Coupons Double-discount coupons redeemed consisting of a combined manufacturer s coupon and the retailer s own store discount must have sales tax based on the regular selling price of the taxable merchandise after deducting only the cash value or face value of the retailer s own discount coupon. Grocery Store Discount Club Cards Many major grocery store chains use discount club cards. Discount club cards provide convenience to consumers by relieving them from having to clip and carry paper coupons, but entitle the cardholder to discounts that are similar to those that can be obtained by using paper coupons. The reduction of the selling price of taxable merchandise through the use of discount cards is considered to be a cash discount. When a consumer uses a discount card, the amount of the discount is not subject to tax, regardless of the source of the discount, i.e., the manufacturer, distributor, or retailer.

8 AUDIT MANUAL CALIFORNIA REDEMPTION VALUE (CRV) Regulation 1589(a) specifically excludes redemption or recycling values of beverage containers from the definition of the term deposit. As such, CRV fees are included in the gross receipts of the seller of the container. Beginning January 1, 2000, the list of beverages subject to CRV was expanded to include nontaxable beverages such as noncarbonated fruit drinks and bottled water. If the beverage is considered a nontaxable food product, the CRV charges related to that product are also nontaxable. Tax still applies to CRV charges related to taxable beverages. All retailers with sales and storage areas totaling more than 4,000 square feet are required to separately state the redemption value in all advertising and on the shelf. The fact that these fees are separately stated (both to the retailer and to their customers) should not affect the method of computing the markup in an audit. The CRV amounts are a cost to the retailer and are a part of the taxable gross receipts. Auditors should ensure CRV amounts are properly accounted for when using markup methods to establish sales. LOTTERY Lottery receipts are not part of a retailer s gross receipts for sales and use tax purposes and should not be included in the taxpayer s reported sales. Auditors should verify that lottery receipts are not included in reported sales. If lottery sales were included in reported sales, auditors should segregate the lottery amount to determine food sales. MISCELLANEOUS OTHER SALES Film Processing Tax generally applies to all charges involved in processing film, including charges for coloring and tinting new pictures. However, itemized charges for developing negatives from a customer s exposed film are generally not taxable. This is to be distinguished from charges for developing by the reverse process method, which is subject to tax (the reverse process method consists of developing the film to a negative and reversing it into a positive, usually in the form of a slide or a home movie film). Rentals Some grocery stores rent videotapes, video equipment, and carpet cleaners. Rentals of videotapes or videodiscs for private noncommercial use are subject to tax. Tax applies to such rentals even though tax was paid on the cost of the item either to the grocer s vendor or directly to the Board. If videotapes and video equipment are rented for a lump-sum charge, tax applies either to the entire charge or to a portion. If the video equipment was acquired tax-paid, there would be no tax on the portion of the charge related to the equipment. Taxable rental receipts would be measured by the ratio of the fair rental value of the videotapes and video equipment as applied to the lump-sum rental charge. If the video equipment was acquired without tax, the entire charge for the videotapes and video equipment is subject to tax. Tax may or may not apply to the rental receipts for carpet cleaner rentals depending on whether tax was paid on the cost of the equipment. Auditors should be aware of such types of rentals to ensure the correct amount of tax is reported. Additionally, if charges for the soap and cleanser supplies are included into the rental price of tax-paid equipment, the grocer is considered the consumer of these supply items. (See Regulation 1660.) Photocopy Machines Some grocery stores have photocopiers for customers to use. Tax applies to sales of photocopies. (See Regulation 1528.)

9 GROCERS PURCHASES SUBJECT TO USE TAX TYPES The average grocer s liability for purchases subject to use tax is generally limited to: (a) Merchandise withdrawn from stock and converted to own use. (b) Capital and expense items purchased under a resale certificate or from an out-of-state retailer. SELF-CONSUMED MERCHANDISE IN GROCERY AUDITS Most grocery stores have self-consumption of taxable merchandise. Some of the more common withdrawals and uses are: Cleaning supplies (paper towels, soaps, sponges, etc.) Other supplies (toilet paper, aspirin, etc.) Taxable items consumed by the owner (sodas, alcohol, cigarettes, laundry soap, etc.) Taxable items given to friends, associates or employees Self-consumption should be discussed at the beginning of the audit and amounts determined. Auditors should be aware that some taxpayers might be reluctant to provide information regarding self-consumption, since they may believe this would increase their tax liability. Auditors should clearly explain to these taxpayers that self-consumption results in tax being due only on the cost of items, rather than the selling price. Grocers often do not maintain records of self-consumption. Therefore, auditors should, with the aid of the taxpayer, estimate the amount of self-consumption as realistically as possible. To support the amount of self-consumed merchandise, the auditor should include a detailed analysis of the consumed merchandise. This includes a breakdown by category (e.g., beer/wine, liquor, soda, cigarettes, and other taxable merchandise) of the volume consumed by the owners and family members, employees, and merchandise given away. Each category should be converted to cost to arrive at the total self-consumption in dollars and then translated into a percentage of total taxable purchases. Use tax should be assessed on any material amounts of self-consumption not reported. Additionally, the recorded cost of goods sold should be reduced by the cost of self-consumed merchandise to accurately mark-up purchases and verify sales. (See Exhibit 5.) If a recommended self-consumption allowance is greater than 3% of total taxable purchases, auditors must provide justification and explanation of the allowance in the audit working paper comments. PROCEDURE WHERE WITHDRAWALS OF MERCHANDISE HAVE NOT BEEN REPORTED A. Where Purchase Ratio Method Is Used Apply the taxable purchase ratio to total amount of merchandise withdrawn by the taxpayer. The amount so computed will be scheduled in the audit working papers. When using this procedure, neither purchases nor total sales need be disturbed. B. Where The Purchase Markup Method Is Used Estimated taxable withdrawals of merchandise should be scheduled at cost in the audit working papers. The amount scheduled should then be deducted from taxable purchases and a weighted markup applied to the remainder of taxable purchases.

10 AUDIT MANUAL PROCEDURE WHERE MERCHANDISE WITHDRAWALS HAVE BEEN REPORTED A. Where Included On Line 1 Where both the taxable and nontaxable items have been included at cost, no adjustment need be made when the purchase-ratio-method is used. If taxable items only have been included, they should be deleted from Line 1 before applying the purchase ratio. The amount deleted should then be scheduled in the audit working papers. B. Where Included On Line 2 When the cost of taxable items only has been reported, no further adjustment need be made. If, however, nontaxable items have been included, or the merchandise has been priced at retail, a credit should be allowed. CAPITAL EXPENDITURES General ledger accounts, purchase invoices, and depreciation schedules should be examined to determine if any capital equipment has been acquired ex-tax during the audit period. Observation of the premises may be helpful in determining any acquisitions of new equipment. PURCHASES SUBJECT TO USE TAX The average grocer makes few direct purchases subject to use tax. However, a grocer may purchase expense items ex-tax from his/her regular wholesale sources. When auditing grocers who are located near cities in bordering states, the auditor should be on the alert for purchases of supplies and equipment from out-of-state retailers.

11 GROCERS AUDIT OF CLAIMED DEDUCTIONS GENERAL Chapter 4 of the Audit Manual outlines general procedures to be used in verifying deductions. Only those deductions particular to grocery stores will be discussed in this chapter. SALES FOR RESALE After having verified the accuracy of sales for resale, the cost of resales as well as the total sales for resale should be eliminated from purchases and total sales, respectively, for purchase-ratio purposes. This procedure is necessary as seldom, if ever, do sales for resale have the same taxable ratio as do sales to consumers. SALES OF FOOD PRODUCTS FOR HUMAN CONSUMPTION Grocers may use any method they choose to compute the amount of sales of food products for human consumption claimed on their sales tax returns. They must, of course, maintain adequate records to support the amount so claimed. Audit procedures for verifying this deduction are explained in subsequent sections. One of the first steps in verifying the claimed exempt food deduction is to determine if the taxpayer correctly classified food products as taxable or nontaxable. Listed below are some common food products sold by grocers and the tax application (see Regulations 1602 and 1603 for additional information). Taxable Food Products Sales of food products for human consumption are generally exempt from tax. However, if an item does not qualify as a food product defined in Regulation 1602, Food Products, or if it is not sold for human consumption, it is generally subject to tax. Examples of items that do not qualify as food products are: Ice Over-the-counter medicines Alcoholic beverages Coloring extracts Tobacco products Dietary supplements, as specified in Regulation 1620 (a)(5), Food products. *Carbonated beverages, including semifrozen beverages containing carbonation (i.e., Slush s ) *Carbonated products that qualify as 100 percent natural fruit juice are not subject to tax. If the fruit juice includes a preservative, such as benzoate or any other additive, it is not considered a natural fruit juice and is subject to tax. Also, a food product sold for consumption by a dog, cat, bird and other domestic pet or for use as fish bait or use by a zoo to feed the animals is subject to tax because it is not sold for human consumption.

12 SALES OF FOOD PRODUCTS FOR HUMAN CONSUMPTION (CONT. 1) Dietary Supplements (Health Foods) AUDIT MANUAL Sales tax generally applies to preparations in liquid, powdered, granular, tablet, capsule, lozenge, and pill form sold as dietary supplements or adjuncts. If an item is sold in one of these specified forms, the following methods may be used to determine its taxability: If an item is described on its label or package as a food supplement, food adjunct, dietary supplement, or dietary adjunct, its sale is subject to tax. If an item is prescribed or designed to remedy specific dietary deficiencies or to increase or decrease generally those areas of human nutrition dealing with vitamins, protein, minerals or calories, its sale is subject to tax. If an item is in one of the above specified forms, it may be taxable if it is generally recognized as a dietary supplement, even though it is not described as such on its package and does not emphasize its vitamin, protein, mineral, or calorie content. Examples include cod liver oil, wheat germ oil, and amino acid products. A health food product sold in liquid, powdered, granular, tablet, capsule, lozenge, and pill form that does not make medicinal claims or meet the test for dietary supplement stated in Regulation 1602(a)(5) would qualify as a food product exempt from tax. In addition, items that are complete dietary foods providing the user in the recommended daily dosage with substantial amounts of vitamins, proteins, minerals and caloric intake will qualify as food products exempt from tax. In evaluating whether a product meets the daily food requirement, multiple daily serving recommendations on the label should be taken into consideration. Herbal Products Sales of herbal products, including teas, are subject to tax if medicinal claims are made on the label or packaging, or in catalogs, brochures, or other information distributed with the product. If an herbal product, including teas, is not marketed or sold as described above, it is considered an exempt food product. For example, if an herbal product is marketed with general claims about making a person feel better, such a statement is not considered to be a medicinal claim. However, when herbal products claim to have general healing properties or to cure or alleviate specific ailments, they are considered nonprescription over-the-counter medicines and subject to tax. Hot Prepared Food Sales of hot prepared food products are subject to tax regardless of whether sold for consumption on the premises or sold to go. A food product is considered a hot prepared food product if it is heated to a temperature above room temperature. Hot food is considered a hot prepared food even if it has cooled by the time of sale since it was intended to be sold as a hot food. Examples of hot prepared food sold by grocers include hot chicken, hot spareribs, hot soups, and hot popcorn. However, tax does not apply to sales of hot bakery items and hot beverages (e.g., coffee, tea, hot chocolate, cider, etc.) if they are sold to go and for a separate price. Sales of combination meals meals (soup and sandwich; or sandwich, chips and drink) for a single price are taxable sales if the meal contains any of the following items: A hot prepared food (such as a hot sandwich) A hot beverage (such as hot coffee or chocolate) Examples of such types of taxable sales include a combination of a hot pastrami sandwich and salad sold for a single price, and a doughnut and hot coffee sold for a single price. August 2004

13 SALES OF FOOD PRODUCTS FOR HUMAN CONSUMPTION (CONT. 2) Food Service Operations GROCERS Some grocers may have snack bars, soda fountains, cafeterias or similar operations. Sales of sandwiches, ice cream, or other food product are subject to tax if sold in a form for consumption at tables, chairs, or counters or from trays, glasses, dishes, or other tableware that grocers provide. For example, if a grocer provides tables and chairs for customer in the store s delicatessen section, tax applies to the food sold for consumption at the tables and chairs. Tax also applies to sales of hot prepared food as discussed above. However, tax does not apply to sales of cold food products sold to go. If a grocer sells a combination meal that includes a cold food item and a carbonated beverage "to go," only the sale of the carbonated beverage is taxable. COMBINATION FOOD PACKAGES Sales of a combination package that includes exempt food products and nonfood products are considered exempt sales of food if: The retail value of the food contents is at least 90 percent of the retail value of the total package contents, and The retail value of the package container is 50 percent or less of the retail value of the entire package. Sales of combination packages that do not meet both of the conditions above are subject to tax based on the selling price of the entire package less the value of the exempt food. Example 1 A grocer sells a gift basket for $60 which includes the following components: Fruit, cheese, crackers (exempt food products) $45.00 Small cheese knife (nonfood product) 5.00 Total value of contents $50.00 Basket Total price of combination package $60.00 The $60 package is considered an exempt sale of food products because it meets both conditions listed above. The value of the food items, $45, is at least 90 percent of the $50 total value of the contents. And, the value of the container (the basket), $10, is less than 50 percent of the retail value of the entire package. Example 2 A grocer sells a party tray for $30 which includes the following: Meat and cheese (exempt food products) $22.00 Serving utensil (nonfood product) 5.00 Total value of contents $27.00 Tray 3.00 Total value of combination package $30.00 In this example, the retail value of the food products is below 90 percent of the retail value of the total package contents ($22/$27= 81%). Consequently, tax applies to the selling price of the package less the retail value of the exempt food products (that is, tax applies to the retail value of the tray and serving utensil). To claim an exemption for the food products in the combination package, the taxpayers records must separately state the value of the food and nonfood items, and those values should be separated on the invoice or receipt. August 2004

14 AUDIT MANUAL COMBINATION FOOD PACKAGES (CONT.) Non-Edible Cake Decorations If a cake or other bakery good is sold for a single price that includes non-edible decorations, the tax application depends upon the value of the non-edible merchandise versus the value of the cake or bakery good. If more than 50 percent of the total retail value of the cake or bakery good represents the value of non-edible decorations, a segregation must be made and the tax is measure by the retail selling price of such non-edible decorations. Separately stated charges for non-edible decorations are subject to tax. REIMBURSEMENT FOR SALES TAX INCLUDED IN TOTAL SALES The general procedure for verifying deduction for sales tax included in total sales is outlined in Chapter 4 of the Audit Manual. The following example illustrates the More Accurate Method. (a) Audited taxable grocery purchases $40,000 (b) Audited sales tax differential (7.25% of Item a) 2,900 (c) Adjusted taxable grocery purchases (Item a + Item b) 42,900 (d) Audited exempt food product purchases 130,000 (e) Total grocery purchases including sales tax (Item c + Item d) 172,900 (f) Exempt food purchases ratio (Item d Item e) 75.19% (g) Total sales including sales tax 254,088 (h) Nongrocery taxable sales per books, including sales tax (if sales are not recorded separately, markup nongrocery taxable cost of goods sold to compute sales then add 7.25% sales tax to total) 31,500 (i) Grocery sales including sales tax (Item g Item h) 222,588 (j) Exempt food sales (Item f x i) 167,364 (k) Sales of taxable items including sales tax (Item g Item j) 86,724 (l) Less taxable items purchased with food stamps (2% of total food stamps redeemed for period, e.g., 2% x $100,000) 2,000 (m) Taxable sales including sales tax (Item k Item l) 84,724 (n) Sales tax included (7.25/ x Item m) 5,727 (o) Measure of tax (Item m Item n) 78,997 (p) Sales tax payable (7.25% x Item o) 5,727 All amounts and the tax rate are for illustration only. The actual amounts and applicable tax rate must be determined in each particular case. An example of the More Accurate Method of computing sales tax included when nongrocery taxable sales are not a factor follows:

15 750, , , ,125 GROCERS REIMBURSEMENT FOR SALES TAX INCLUDED IN TOTAL SALES (CONT.) Facts: Total Grocery Sales including Sales Tax $1,250,000 Purchases: Food Products $ 750,000 75% Grocery Taxable 250,000 25% $1,000, % Computation: Exempt Food Products Ratio: 750,000 = 73.66% ( 7.25% 250,000) Total Sales Including Tax $1,250,000 Less Food Products (73.66% x 1,250,000) 920,750 Taxable Sales Including Tax 329,250 Less Taxable Items Purchased with Food Stamps (2% x total food stamps redeemed for period, e.g., 2% x $100,000) 2,000 Taxable Sales Including Tax 327,250 Sales Tax Included (7.25/ x $327,250) 22,122 Taxable Sales (ex-tax) $305,128 FEDERAL FOOD STAMPS Tangible personal property eligible to be purchased with federal food stamps and so purchased is exempt from sales and use tax (Regulation (c)). This includes sales that would otherwise be taxable, e.g., nonalcoholic carbonated beverages, ice, food coloring extract, etc. Grocers who receive gross receipts in the form of federal food stamps may claim a deduction for redeemed food stamps on taxable merchandise sold. Retailers are prohibited from collecting sales tax reimbursement on items purchased with food stamps even though such purchases are taxable when purchased with cash. The Department of Agriculture, Food, and Nutrition Service (FNS) will ensure that retail food stores are not charging sales tax on eligible food items purchased with food stamps. In view of the enforcement procedures by FNS and in the absence of evidence to the contrary, it will be presumed that sales tax reimbursement is not being collected on sales of eligible items paid for with food stamps. Retailers who accept federal food stamps are required by the FNS to complete a redemption certificate when they deposit food stamps. Each retailer is assigned an authorization number by FNS and must write this number on the redemption certificate. However, the retailer does not keep the redemption certificate. The bank, or other financial institution that cashes food stamps, gives the retailer a receipt for the deposit and submits the certificate to the FNS. The receipts do not always indicate that the bank deposit includes food stamps. Therefore, not all retailers will have supporting documentation with respect to the total food stamp coupons redeemed.

16 a ( a + b) = AUDIT MANUAL FEDERAL FOOD STAMPS (CONT.) When a retailer receives payment partly in the form of cash and partly in the form of food stamps, the food stamps must be applied first to the gross receipts which would have been subject to tax. The following example is how sales paid with both cash and food stamps should be handled: In this example the customer is paying for their groceries with $15.00 in food stamps and the balance in cash. a. Taxable Food Items $20.00 b. Non-taxable Food Items c. Taxable Non-food Items (non eligible food stamp items) 5.00 d. Total Purchases $60.00 e. Food Stamps Received f. Cash Received (includes.73 tax) Total Paid $60.73 Amount of Sale Subject to Sales Tax (a e + c) $10.00 If this customer had food stamps that exceeded the total amount of eligible taxable food items, the remainder should be applied to non-taxable food items only. Tax applies to all sales of taxable items that are not eligible food stamp items. Retailers are authorized to report the deduction for food stamps either on an actual basis or by taking a deduction on their sales tax return in the amount of two percent (2%) of the total amount of food stamps redeemed in the period for which the return is filed. Effective January 1, 1993, grocers may claim amounts in excess of two percent whenever the following computation results in a greater percentage: total purchases of taxable items eligible to be purchased with food stamps divided by an amount equal to the total of the exempt food product purchases plus the purchases of taxable items eligible to be purchased with food stamps. For example, assume the following total purchases for reporting period: Taxable items eligible to be purchased with food stamps $5,000 (a) Exempt food products 130,000 (b) The allowable percentage to be applied to the retailer s total food stamps redeemed is computed as follows: $ 5,000 $135,000 = 3.7% In auditing grocers claiming the deduction based on a percentage of the food stamps redeemed, the amount recorded as total food stamps redeemed should be accepted if the amount is reasonable for the taxpayer s location and product mix. If the audit is based on a markup of taxable sales, the auditor should give effect to food stamp redemptions on eligible taxable items. If a food stamp deduction is not claimed by the taxpayer, appropriate comments should be made in the audit working papers (e.g., none accepted, etc.). Retailers who report on the tax accrual method are accounting for their food stamp redemptions on an actual basis and therefore should not be claiming the exemption based on one of the in lieu methods. The acceptable method for calculating the food stamp redemption deduction for taxpayers reporting on the purchase-ratio method or grocer s formula is explained in Section

17 GROCERS TRADING STAMPS Grocers may issue trading stamps in connection with sales made to customers. The cost of the stamps purchased by the grocer constitute cash discounts. Generally, grocers do not issue these stamps in connection with sales of distilled spirits, cigarettes, beer, wine, milk, or publications. (Refer to Chapter 4 regarding appropriate reimbursement of tax.) The deduction for trading stamps is allowable only on the cost of stamps given in connection with taxable sales. In computing the deductible amount for trading stamps, the cost of the trading stamps should be prorated between the taxable and exempt sales on which stamps are given. The ratio may be computed on a test basis, i.e., the ratio obtained after adjusting taxable and total sales for a representative period, by the amount of taxable and total sales respectively, on which stamps are not given. This procedure should be followed in all cases where the adjustments would affect the ratio significantly and the deduction is of material consequence. See Regulation 1700(b)(5)(A)(2) for excess tax reimbursement on trading stamps. In some cases, this procedure may not be necessary. In the case of many small stores where the amount of stamps involved is minor, the deduction may be based on the unadjusted taxable sales ratio. This short-cut procedure should be used only when the result of adjusting for sales on which stamps are not given, would be insignificant. Often trading stamp companies rebate part of the cost of the stamps above a certain percentage of sales. Miscellaneous sources of income should be examined for such rebates. BOTTLE DEPOSITS AND OVER-RINGS Bottle deposits are not part of gross receipts from sales. If such deposits are segregated, they will be excluded from total sales. In this case, care should be exercised to insure that refunds of such deposits are not netted from total sales. If it is established that bottle deposits are included in total sales, but that refunds of such deposits have been treated as cash payouts and not netted from total sales, the deduction claimed for this item should be allowed without further verification unless it is out of proportion to the volume of sales. When deposits are not segregated but are included in total sales, and deposit refunds are netted from total sales, it will be presumed in the absence of evidence to the contrary, that the total deposits received are equal to the deposits refunded. Deductions claimed for over-rings, if reasonable, may be allowed without further verification. If this deduction appears excessive, verification should then be made by test checking the documents supporting the over-rings for several scattered days. MEAT SCRAPS SOLD AS BY-PRODUCTS Meat scraps sold to rendering plants should be treated as sales for resale. These sales should be excluded from total grocery sales for purchase-ratio purposes. Since these are sales of a by-product, no adjustment should be made to the cost of meat purchases.

18 AUDIT MANUAL BAD DEBTS Grocers can claim a bad debt deduction for the amount of taxable sales reported and paid that were found to be uncollectible and charged off for income tax purposes. For grocers, bad debts are normally due to customer checks that were returned unpaid by the bank. Since some grocers may fail to claim a bad debt deduction, auditors should determine whether a taxpayer is entitled to a bad debt deduction. If a taxpayer is entitled to claim a bad debt deduction and failed to do so, the auditor should inform the taxpayer of the information necessary to properly claim this deduction (Regulation 1642) and make any necessary adjustments in the audit based on the information provided by the taxpayer. Since a single sale by a grocer normally includes both taxable and nontaxable items, a grocer s bad debt deduction may be determined by multiplying the total bad debts by the ratio of total taxable sales to total sales for the reporting period (or audit period). A bad debt deduction should be claimed in the period that the amount was found worthless and charged off for income tax purposes. When a check is cashed for an amount in excess of the total sale, that excess portion over the sale amount is not deductible as a bad debt. Chapter 4 Section discusses further audit procedures and special considerations for bad debt deductions. MISCELLANEOUS OTHER DEDUCTIONS Prepaid Telephone Debit Cards Sales of prepaid telephone debit cards are not subject to tax. These transactions are considered sales of future telephone service rather than sales of tangible personal property. However, a sale of a prepaid telephone card for its value as a collectible item rather than for future telephone service is a sale subject to tax. This also holds true when the card is resold after the telephone service expires or is fully depleted. New cards sold as collectibles often have a small amount of future telephone service included in the price. Cards sold for a price that exceeds the value of any included telephone service are sold for their value as collectibles. Point-of-Sales Fees Tax does not apply to separately stated charges representing fees for using a debit card. Such fees are related to bank fees and are not considered compensation for a sale. See Regulation Vending Machine Commissions Commissions received from vending machine operators who have placed vending machines in a grocer s store are not subject to tax. However, if a grocer sells it own products through vending machines see Regulation 1574, Vending Machines Operators.

19 GROCERS GROCERS REPORTING METHODS GENERAL Grocers may use any method of determining the amount of exempt food sales and taxable items so long as the method used accurately discloses the correct amount of tax due. Regardless of the method used, the taxpayer must demonstrate, by records which can be verified by audit, that the method used accurately discloses the correct amount of tax. Grocers generally use one of the following methods of reporting taxable sales: (a) Purchase-Ratio Method. (See Section ) (b) Modified Purchase-Ratio Method. (See Section ) (c) Cost Plus Markup Method Taxable Merchandise. (See Section ) (d) Retail Inventory Method. (See Section ) (e) Extending Taxable Merchandise to Retail Price. (See Section ) (f) Electronic Scanning Systems. (See Section ) (g) Sales Tax Ring-Up Method. (See Section ) (h) Taxable Sales Ring-Up Method. (See ) (i) Estimating. (See Section ) (j) Two or more of the above methods. RETAIL INVENTORY METHOD Under this method (see Regulation ), all purchases are immediately priced at retail and all control records reflect the retail values. As a rule, its use by grocers is restricted to the larger chain organizations. Verification procedure to be used is the same as in Section EXTENDING TAXABLE MERCHANDISE TO RETAIL METHOD This reporting method contemplates that the taxpayer will report tax based on the retail selling price of all taxable purchases during a reporting period rather than on actual taxable sales made during the period. Verification procedure should cover: (a) Accuracy of total purchases. (b) Accuracy of purchase segregation. (c) Accuracy of extensions. (d) Accuracy of adjustments for inventory fluctuations. (e) Accuracy of adjustments for markdowns, markons, quantity sales and case sales. (f) Accuracy of adjustment for shrinkage. (See Section ) (g) Accuracy of adjustment for self-consumption. (See Section )

20 AUDIT MANUAL SALES TAX RING-UP METHOD Under this method, sales tax ring-ups at the cash register are converted to the equivalent taxable measure to determine taxable sales for the reporting period. Use of this method is generally not satisfactory because of several factors. For example: Checkout clerks may not be well informed on the taxability of all items sold. Checkout clerks often work under pressure, which can lead to errors in classifying items or errors in the amount of tax reimbursement added. It is sometimes trade practice to sell certain types of merchandise, such as cigarettes and tobacco, at a tax-included price. Since this method is susceptible to many errors, auditors should be aware when a grocer utilizes it. Auditors should verify the following: (a) Accuracy of recorded sales tax by tracing cash register tape totals to sales register (or other sales summary books) for several representative periods. (b) Proper sales segregation on cash register tapes by testing a representative period using the markup method. TAXABLE SALES RING-UP METHOD This method is similar to the sales tax ring-up method, except that under this method the taxable sales amounts are recorded on a separate key of the cash register and compiled to determine taxable sales for the reporting period. As with the sales tax ring-up method, this method is susceptible to many errors. Auditors should be aware when a grocer utilizes this method and use similar verification procedures discussed in Section ESTIMATES The following methods for reporting tax liability based on estimates are not recommended, but may be found in use by the taxpayer: Estimates based on tax reported in a prior period. Estimates based on a ratio of taxable sales to total sales in a prior period. Estimates based on the application of unsubstantiated markups or based on other methods that have not been approved by the Board. Auditors should use appropriate markup methods to verify if the taxpayer s estimate reasonably discloses the correct amount of tax due.

21 GROCERS PURCHASE-RATIO METHOD GENERAL If the taxpayer is reporting by use of the purchase-ratio method, the purchase-ratio method should be used for audit purposes unless it is determined that not all sales are recorded. In such instances, the markup method should generally be used. The validity of the purchase-ratio method is based on the premise that the over-all markup on food products is the same as on taxable merchandise. Authorization for the use of this method is contained in Regulation Two basic methods used in reporting sales of exempt food products are: (a) The Simple Method Use of this method does not allow a tax included deduction. Exempt Food Purchases Total Grocery Sales Exempt Food Purchases + Taxable Grocery Purchases (tax included) (b) The More Accurate Method Exempt Food Purchases Exempt Food Purchases + Taxable Grocery Purchases %* of Taxable Grocery Purchases Total Grocery Sales (tax included) *Use applicable tax rate. This method allows a tax included deduction. (See Section ). The Simple Method is most often used by small grocers who would benefit only slightly by the additional calculations required by the More Accurate Method. If use of the More Accurate Method would result in a substantial difference, if tax included has been claimed, or if other revisions are required, the taxpayer should be given the benefit of the use of this method. Sections through describe the items to be included and excluded from the specific categories in the formula for the purchase-ratio method. Where concessionaire sales and purchases are included in the records, they should be eliminated before the computation of the food product percentage is made. An example of the application of the purchase-ratio method is shown in Exhibits 1 through 4 following the text of this chapter. EXEMPT FOOD PURCHASES This classification includes purchases of all items meeting the definition of food products for human consumption as defined in Section 6359 and Regulation Purchases for all grocery departments operated by the taxpayer such as meat, fruit, produce, delicatessen (except ingredients for hot prepared food or food sold for immediate consumption at facilities provided by the grocer), and bakery should be included. Care should be taken to exclude from exempt food purchases all purchases of operating supplies, paper bags, and expense items since these are often billed along with groceries by the larger wholesale grocers.

22 AUDIT MANUAL TAXABLE GROCERY PURCHASES This classification includes purchases of all taxable items other than the type of items classified as nongrocery taxable in Regulation See Exhibit 8. It does not include purchases of gasoline, feed for farm animals, fertilizers, or purchases of ingredients for products sold in snack bars, restaurants, or as hot prepared food products, or sold for immediate consumption at facilities provided by the grocer (see Section ). SELF-PERFORMED COSTS Exempt food purchases and taxable grocery purchases do not include the cost of processing, manufacturing, warehousing, transportation and other costs, if these operations are self-performed. Some examples of such costs are; meat cutting and wrapping, produce preparation, meat plant operation, milk plant operation, operating bakery department, preparation of cold salads in a delicatessen department, etc. When the purchase-ratio method is used for reporting purposes, amounts subject to the ratio include only the cost of merchandise purchased from others, and excludes any selfperformed additional costs. If a grocer includes self-performed labor or overhead costs in the purchase-ratio method, he/she is using a modified purchase-ratio method. Grocers using a modified method must demonstrate that the method does not result in an overstatement of the food products deduction (see Section ). TOTAL GROCERY SALES This classification includes sales of all grocery departments operated by the taxpayer including meat, fruit, produce, delicatessen (except hot prepared food or food sold for immediate consumption at facilities operated by the grocer), beverage (except distilled spirits), and bakery departments. Sales tax reimbursement applicable to grocery department sales, amounts received or accrued from manufacturers or others for coupons (excluding handling allowances) redeemed by customers, and the face value of federal food stamps should also be included in grocery sales for purchase-ratio purposes. The following receipts should be excluded for ratio purposes: (a) Selling price (including tax) of nongrocery taxable items that were eliminated from taxable grocery purchases. (b) Sales not made in the regular course of business such as sales of equipment. (c) Sales of meat scraps to rendering plants (see Section ). (d) Sales of gasoline, farm seeds, fertilizers, snack bar or restaurant operations. (e) Deposits (see Section ). BEVERAGE DEPARTMENT SALES All beverage department sales and purchases, except distilled spirits and other nongrocery taxables, should be included in the formula calculations.